Cost Segregation Studies | Valuable Benefits Under New and Old Tax Rules
Prepared by Michael T. McCarthy, CPA, CVA– Managing Partner
Cost Segregation – A great way to reduce tax burden in any year, but if you built a new building in 2017, it may be a great way to take advantage of the new tax laws by accelerating depreciation expense into a year with higher tax rates.
Under the new Tax Cuts and Jobs Act signed by President Trump in 2017, individual rates will drop slightly for the highest earners from 39.6% to 37%, but corporations will see significant savings with a drop from 35% to 21%.
Therefore, if you can take a big deduction in 2017, you get real bang in tax savings, certainly more than you would if you take the same deduction in 2018 or later.
Regardless of the tax rate reductions, cost segregations are a great tax planning strategy: lower risk and well supported by tax law. If you are not familiar with a cost segregation study, in simple terms, it is a way to segregate the assets of a new building or renovation project into component parts for the purpose of accelerating deprecation.
You build a new building for $3 million dollars. Most people would take the $3 million cost and depreciate it over 39 years for tax purposes so they get a depreciation deduction of $77,000 per year. At a 35% tax rate, this saves them $26,950 in taxes per year.
If you segregate the building into say $750,000 in equipment (like HVAC systems and appliances) and $750,000 in furnishings (like carpet and cabinets and decorative trim and such), that leaves only $1.5 million to be depreciated as a building over 39 years. The result is a first-year deduction using bonus depreciation and accelerated methods for the equipment and furnishings. Instead of saving $17,950 in taxes in year one you get back over $500,000 in tax savings. The cash flow in your pocket can be used to invest in your business or pay down your note on the new building. Either way, getting a significant cash flow amount in your pocket is good thing.
Now consider the new tax rates. If you can take that deduction in 2017 and save 35% in taxes versus in the future only getting 21% tax savings, the impact of the deduction is much more significant.
For example, if a company had a cost segregation performed resulting in a 2017 extra depreciation deduction of $750,000, the tax savings would be $262,500 at a 35% tax rate ($750,000 x 35%). If the company did not do the cost segregation, that same $750,000 in cost would be depreciated over 39 years and the tax savings would be at the 21% rate of $157,500. Further that is not $157,500 of tax savings all in one year. It is over time, so the present value of those savings is much less. That is, you save $105,000 in absolute dollars but close to $150,000 in present value benefit by doing the cost segregation study.
The previous discussion presumes you acquired the building components prior to September 27, 2017 so that they are being depreciated under the old rules. If the building was placed into service before the end of 2017, any building components acquired after September 27th are eligible for 100% bonus depreciation, making the case for a cost segregation analysis even more compelling.
If you have purchased or constructed a building in the last five years, a cost segregation study may be appropriate for your business, but we need to get started now, and get this tax deduction into your 2017 tax return to take advantage of the current higher rates. If you have already filed your return, an amended return can be filed once the cost segregation is complete.